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Emerging markets: Tempered expectations despite recent surge

By
Joseph Devine

May 20, 2016

Emerging market equities appear to have bounced back during the first quarter of 2016, following a string of disappointing returns during the past five years or so. This sudden surge in performance has prompted investors to ask, “Does the upswing have legs? If not, what message should we take from this development?”

First, we should make clear that recent performance does not lead us to be unreasonably bullish on the asset class as a whole. In fact, it’s more accurate to say that we’re somewhat neutral, if not altogether agnostic, on the direction of emerging market equities as an asset class. We think it makes more sense to focus on structural themes within emerging markets, particularly those that have the potential to support equity prices in a direct manner.

Put another way, we believe there is little sense in trying to pick what we consider to be winners at the country or regional levels, preferring instead to concentrate on identifying developments on the ground that we believe are bringing about fundamental change and creating investment opportunities along the way.

One example that comes to mind involves the changing lifestyles of emerging market consumers. In developing countries, a nascent middle class is gaining traction. We are studying this phenomenon as we consider the investment ramifications that could play out, or are indeed already playing out, in areas that are geared to domestic demand, such as consumer products and healthcare. China is one such country, as the evolution of its two-speed economy is relying more on the consumer sector and less on the industrial sector.

A puzzle with many pieces

Emerging markets are inherently dynamic. Consider the first quarter of 2016, when returns among the 23 countries within the MSCI Emerging Markets Index diverged greatly, much as they have for the past decade. This disparity of returns was exemplified further in the range of outcomes for the quarter. At the stronger end, outsized returns were posted by countries like Turkey and Russia, advancing by 19.8% and 16.3%, respectively, while countries like Greece and Egypt were on the weaker end of the spectrum, declining by 16% and 2%, respectively. This broad distribution of returns is evidenced at the regional level as well, as shown in the chart below.

Regional index returns: Largely independent of each other

Past performance does not guarantee future results.

Chart is for illustrative purposes only.

Data: MSCI

Looking at developing nations around the world, we see that sources of support for equities are just as varied as total returns have been. Commodity prices are largely responsible for recent Latin American gains, for instance, while places like Turkey have seen shares rise on the prospect of looser monetary policy.

Despite attempts to identify one omnipresent source of support for the quarter, investors are left with the fact that no single development was the lone impetus for equity performance across developing countries. That said, it’s worth pointing out one particularly notable factor that had substantial reach around the world: the U.S. Federal Reserve’s insistence on holding interest rates at low levels. To a large degree, equity markets are saddled by the notion that U.S. rates are unlikely to rise very much during the balance of 2016, which means there will likely be little pressure for the dollar to strengthen.

This translates to support for emerging market assets, as was the case during the first quarter. Gains in oil prices helped as well, as did signs of stability in China’s economy. But as we look at such drivers, we caution that it’s difficult to predict how long they will persist. The Fed’s current dovish stance, for instance, is causing some investors to assume that the central bank will never turn hawkish again, or at least not for a very long time. But in reality, it’s probably prudent to assume that the Federal Open Market Committee (FOMC) will be back on scene at some point.

Expect turbulence, but don’t rule out pockets of opportunity

Are we prepared to say that the prolonged softness in emerging markets has come to an end? Probably not. Sure, there are subtle changes that made emerging market stocks appealing in recent months, but we don’t believe it’s prudent to declare a swift conclusion to the underperformance. Perhaps we can concede that markets are experiencing a change in tone for the time being, but as noted above, we think it’s too early to make sweeping predictions about long-term change. (Furthermore, we’d argue that rarely is there an appropriate time for such predictions.)

In our opinion, it makes sense to expect emerging markets to remain somewhat volatile, particularly when considering the unpredictable interaction between commodity prices, economic growth, investor sentiment, monetary policy developments around the world, and other factors. Against this backdrop, we recommend that investors be wary of changing their convictions based on short-term swings in market performance.

Speaking of convictions, part of our plan in the coming quarters is to emphasize companies that stand to benefit as more and more families enter the consumer class. In places like China, India, and Mexico, economic activity is increasingly being driven by domestic growth and rising consumer spending.

As a whole, emerging markets can often suffer from a fair amount of distortion, which can be created by foreign exchange considerations, liquidity concerns, a relative lack of transparency, and misgivings about the general trustworthiness of economic and market data. Statisticians readily admit the difficulty of measuring economic growth in places that are undergoing rapid change, which is often the case within emerging markets.

Conditions like these have been part and parcel of the emerging markets topography since the inception of the asset class. With that in mind, it bears repeating that in times of uncertain macro developments, one notable path is to focus on company fundamentals, seeking to identify companies that are prepared to deliver stable performance in spite of changes in macro conditions.

The views expressed represent the Manager's assessment of the market environment as of May 2016 and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager's views.

Carefully consider the Funds' investment objectives, risk factors, charges, and expenses before investing. This and other information can be found in the Funds' prospectuses and their summary prospectuses, which may be obtained by visiting delawarefunds.com/literature or calling 800 523-1918. Investors should read the prospectus and the summary prospectus carefully before investing.

IMPORTANT RISK CONSIDERATIONS

Investing involves risk, including the possible loss of principal.

Past performance does not guarantee future results.

International investments entail risks not ordinarily associated with US investments including fluctuation in currency values, differences in accounting principles, or economic or political instability in other nations. Investing in emerging markets can be riskier than investing in established foreign markets due to increased volatility and lower trading volume.

The MSCI EAFE (Europe, Australasia, Far East) Index is a free float-adjusted market capitalization weighted index designed to measure equity market performance of developed markets, excluding the United States and Canada.

The MSCI World Index is a free float-adjusted market capitalization weighted index designed to measure equity market performance across developed markets worldwide.

Joseph Devine

Joseph Devine biography

Joseph Devine

Senior Vice President, Chief Investment Officer — Global Ex-US Equity

Joseph Devine joined Macquarie Investment Management (MIM) in March 2016 as head of the Global Ex-US Equity team. Previously, he worked at UBS Asset Management from July 2007 to February 2016, first as senior portfolio manager and then as head of the Global ex-US Growth Equities team. Prior to UBS, Devine worked at Nicholas-Applegate Capital Management from July 2005 to July 2007 as lead portfolio manager for the Emerging Markets and Pacific Rim portfolios of the International Growth team. Prior to that, he was an Asian equity analyst at Duncan-Hurst Capital Management. Devine was also responsible for the firm’s Global Emerging Markets portfolio. He previously held trading positions at Peregrine Investment Holdings in the Philippines and Singapore, and at Credit Suisse First Boston in Hong Kong and Singapore. Devine earned a bachelor’s degree at the University of Southern California and an MBA at the Marshall School of Business at the University of Southern California.

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